Chapter 12

Pricing

Key issues

1. why and how firms price discriminate

2. perfect price discrimination

3. quantity discrimination

4. multimarket price discrimination

5. two-part tariffs

6. tie-in sales

Nonuniform pricing

• prices vary across customers or units• noncompetitive firms use nonuniform

pricing to increase profits

Single-price firm

• nondiscriminating firm faces a trade-off between charging• maximum price to consumers who really want

good • low enough price that less enthusiastic

customers still buy

• as a result, single-price firm usually sets an intermediate price

Price-discriminating firm

• avoids this trade-off• earns a higher profit by charging

• higher price to those willing to pay more than the uniform price: captures their consumer surplus

• lower price to those not willing to pay as much as the uniform price: extra sales

Extreme examples of tradeoff

• maximum customers will pay for a movie:• college students, $10• senior citizens, $5

• theater holds all potential customers, so MC = 0

• no cost to showing the movie,

so = revenue

Example 12.1a

PricingProfit from 10

College StudentsProfit from 20 Seniors

Total Profit

Uniform, $5 $50 $100 $150

Uniform, $10 $100 $0 $100

Price discriminate $100 $100 $200

Example 12.1b

Pricing

Profit from 10 College Students

Profit from 5 Seniors

Total Profit

Uniform, $5 $50 $25 $75

Uniform, $10 $100 $0 $100

Price discriminate

$100 $25 $125

Broadway theaters

increase their profits 5% by price discriminating rather than by setting uniform prices

Geographic price discrimination

• admission to Disneyland is $38 for out-of-state adults and $28 for southern Californians

• tuition at New York’s Fordham University is $4,000 less for commuting first-year students than for others

Successful price discrimination

• requires that firm have market power • consumers have different demand

elasticities, and firm can identify how consumers differ

• firm must be able to prevent or limit resales to higher-price-paying customers by others

Preventing resales

• resales are difficult or impossible when transaction costs are high

• resales are impossible for most services

Prevent resales by raising transaction costs

• price-discriminating firms raise transaction costs to make resales difficult

• applications:• U.C. Berkeley requires anyone with a student

ticket to show a student picture ID• Nikon warranties cover only cameras sold in

this country

Prevent resales by vertically integrating

• VI: participate in more than one successive stage of the production and distribution chain for a good or service

• VI into the low-price purchasers

Prevent resales by government intervention

• governments require that milk producers charge higher price for fresh use than for processing (cheese, ice cream) and forbid resales

• governments set tariffs limiting resales by making it expensive to import goods from lower-price countries

• governments used trade laws to prevent sales of certain brand-name perfumes except by their manufacturers

Flight of the Thunderbirds

• 2002 production run of 25,000 new Thunderbirds included only 2,000 for Canada

• potential buyers are besieging Ford dealers in Canada• many hope to make a quick profit by reselling these cars in the

United States• reselling is relatively easy and shipping costs are relatively low

• why a T-Bird south?• Ford is price discriminating between U.S. and Canadian customers• at the end of 2001, Canadians were paying $56,550 Cdn.

(Thunderbird with the optional hardtop), while U.S. customers were spending up to $73,000 Cdn.

Thunderbirds (cont.)

• Canadian dealers try not to sell to buyers who will export the cars

• dealers have signed an agreement with Ford that explicitly prohibits moving vehicles to the United States

• dealers try to prevent resales because otherwise Ford may cut off their Thunderbirds or remove their dealership license

• one dealer said, “It’s got to the point that if we haven’t sold you a car in the past, or we don’t otherwise know you, we’re not selling you one.”

• nonetheless, many Thunderbirds were exported: eBay listed dozen of these cars on a typical day

3 types of price discrimination

• perfect price discrimination (first-degree): sell each unit for the most each customer is willing to pay

• quantity discrimination (second-degree): charges a different price for larger quantities than for smaller ones

• multimarket price discrimination (third-degree): charge groups of customers different prices

Perfect-price-discriminating monopoly

• has market power• can prevent resales• knows how much each customer is willing

to pay for each unit purchase (all knowing)

All-knowing monopoly

sells each unit at its reservation price• maximum price consumers will pay (captures

all possible consumer surplus)• height of demand curve• MR is the same as its price (AR)

Figure 12.1 Perfect Price Discrimination

p, $ per unit

6

5

4

3

2

1

Q, Units per day6543210

MCe

Demand, Marginal revenueMR1 = $6 MR2 = $5 MR3 = $4

Perfect price discrimination properties

• perfect price discrimination is efficient• competition and a perfectly discriminating

monopoly• sell the same quantity• maximize total welfare: W = CS + PS• have no deadweight loss

• consumers worse off (CS = 0) than with competition

s c d

p, $ per unit

E

D

CB

A

Q, Units per dayQ Q = Q

MCs

Demand, MR

MR s

pc = MCcec

esps

p1

MC1

MC

d

Amazon

• in 2000, Amazon revealed that it used “dynamic pricing”: gauges shopper’s desire and means, charges accordingly

• example • a man ordered DVD of Julie Taymor’s “Titus” at

$24.49• checks back next week and finds price is $26.24• removes cookie: price fell to $22.74

• after newspaper articles, Amazon announced it had dropped this policy

Botox revisited

• how much more would Allergan earn from Botox if it could perfectly price discriminate?

Application Botox Revisited

p, $ per vial

1.30 2.612.75

A ≈ $187.5 million

C ≈ $187.5 million

B ≈ $375 million

Demand

Q, Million daily doses of Botox

75.0

7.5

0

es

eMC

MR

143.0

c

Solved problem

How does welfare change if firm in Table 12.1 goes from charging a single price to perfectly price discriminating?

Table 12.1a

PricingProfit from 10

College StudentsProfit from 20 Seniors

Total Profit

Uniform, $5 $50 $100 $150

Uniform, $10 $100 $0 $100

Price discriminate $100 $100 $200

Answer: Panel a

• welfare is same with single price or price discrimination because output unchanged

• single price: if theater sets a single price of $5• it sells 30 tickets and = $150• 20 seniors pay their reservation price so CS = 0• 10 college students (reservation prices of $10) have CS

= $50• welfare = $200 = profit ($150) + consumer surplus

($50)

If firm perfectly price discriminates

• it charges all customers their reservation price so there’s no consumer surplus

• seniors pay $5 and college students, $10• firm's profit rises to $200• welfare

W = $200 = profit ($200) + CS ($0) is same under both pricing systems where

output stays the same

Table 12.1b

Pricing

Profit from 10 College Students

Profit from 5 Seniors

Total Profit

Uniform, $5 $50 $25 $75

Uniform, $10 $100 $0 $100

Price discriminate

$100 $25 $125

Answer: Panel b

• welfare is greater with perfect price discrimination where output increases

• if theater sets single price of $10• only college students attend and have CS = 0 = $100• W = $100

• if it perfectly price discriminates:• CS = 0 =$125• W = $125

Quantity discrimination

• firm does not know which customers have highest reservation prices

• firm might know most customers are willing to pay more for first unit (demand slopes down)

• firm varies price each customer pays with number of units customer buys• price varies only with quantity: all customers pay the

same price for a given quantity • note: not all quantity discounts are a form of price

discrimination

Utility block pricing

• public utility (electricity, water, gas…) charges • one price for the first few units (a block) of

usage • different price for subsequent blocks

• both declining-block and increasing-block pricing are common

p1, $ per unit

30

50

70

90

Q, Units per day20 40 900

m

(a) Quantity Discrimination

Demand

A =$200

C =$200

B =$1,200 D =

$200

p2, $ per unit

30

60

90

Q, Units per day30 900

m

(b) Single-Price Monopoly

Demand

F = $900G = $450

MR

E = $450

Figure 12.3 Quantity Discrimination

Multimarket price discrimination

• firm knows only which groups of customers are likely to have higher reservation prices than others

• firm divides potential customers into two or more groups

• firms set a different price for each group

Theater

• senior citizens pay a lower price than younger adults at movie theaters

• by admitting people as soon as they demonstrate their age and buy tickets, theater prevents resales

International price discrimination: Cars

• even including shipping and customs, European price for BMW 750IL

• price is 13.6% more from an American firm than imported from Europe

International price discrimination: Software

• Australia's Prices Surveillance Agency criticized American software industry for charging Australians 49% more than Americans,

• then, Agency called for an end to import restrictions so that Australian retailers could import software directly

Price discriminating: 2 groups

• marginal cost = m

• monopoly charges Group i members pi for Qi units

• profit from Group i is

i= piQi – mQi

To maximize total profit

• monopoly sets its quantities so that marginal revenue for each group i, MRi, equals common marginal cost, m:

MR1 = m = MR2.

• example: Sony’s Aibo robot dog

pJ , $ per unit

QJ, Units per year

DWLJ

DJ

CSJ

J

MRJ

pJ = 2,000

500

3,500

0

MC

QJ = 3,000 7,000

(a) Japan

Figure 12.4 Multimarket Pricing of Aibo

pUS, $ per unit

QUS, Units per year

DWLUS

DUS

CSUS

US

MRUS

pUS = 2,500

500

4,500

0

MC

QUS = 2,000 4,500

(b) United States

Profit-maximizing condition

• MRi = pi(1 + 1/i), so

• MR1=p1(1 + 1/1) = m = p2(1 + 1/2) = MR2

21

2

1

11

.1

1

p

p

Solved problem

• monopoly sells in two markets• constant elasticity of demand is

1 = -2 in first market

2 = -4 in second market

• MC = $1• resales are impossible• what prices should monopoly charge?

Answer

p1 = 1/(1 – ½) = 2

p2 = 1/(1 – ¼) = 4/3

p1/p2 = 2/(4/3) = 1.5

11 1i

i

p MC

11/ 1i

i

p

Coca-Cola Version 1

• a two-liter bottle of Coke costs 50% more in the U.K. than in EU nations (SF Chronicle, May 17, 2000: D2)

• if Coke’s marginal cost is the same for all European nations, how does the demand in the U.K. differ from that in the EU?

Answer

• pUK/pEU = 1.5

• an example that is consistent with this ratio is UK = - 2 and EU = -4

• generally:

or 1.5EU - UK = 0.5 UK EU

1 11 / 1 1.5

EU UK

Generics and brand-name loyalty

Why do prices of some brand-name pharmaceutical drugs rise when equivalent, generic brands enter the market?

Entry of generics

• generics enter when patent for profitable drug expires• generics: 40% of U.S. pharmaceutical sales by volume• name-brand drugs with sales of about $20 billion went

off patent by 1997

• most states allow/require pharmacist to switch prescription from more expensive brand-name product to generic unless doctor or patient object

Price effects

18 major orally-administered drug products that faced generic competition 1983-1987• on average for each drug, 17 generic brands

entered and captured 35% of total sales in first year

• price effects• brand-name drug prices rose an average of 7%• but average market price fell over 10%• because generic price was only 46% of brand-name

price

Explanation

• customers with different demand elasticities• some are price sensitive: willingly switch to less

expensive generic drugs• others are unwilling to change brands• AARP survey found that people 65 and older are 15%

less likely than people 45 to 64 to request generic versions of a drug from their doctor or pharmacist

• introduction of generics makes demand facing brand-name drug less elastic

Identifying an individual’s group

• identify using observable characteristics of consumers price elasticities

• identify consumers based on their actions: consumers self-select into a group

Why firms use self-identification

• each price discrimination method requires that, to receive a discount, consumers incur some cost, such as their time

• otherwise, all consumers would get a discount

• by spending extra time to obtain a discount, price-sensitive consumers differentiate themselves from others

Getting consumers to identify themselves: Coupons

• self-selection: people who spend their time clipping coupons buy goods at lower prices than those who value their time more

• coupon-using consumers paid $24 billion less than other consumers in the first half of 1990s

Airline tickets and hotel rooms

• self-selection (business vs. vacation travelers): cheap fares require advanced purchase and staying over a Saturday night

• Sheraton and other hotel chains offer discounts for rooms booked 14 days in advance for the same reason

Reverse Auctions

• priceline.com uses a name-your-own-price or reverse-auction to identify price sensitive customers

• a customer enters a relatively low price bid for a good or service, such as airline tickets

• merchants decide whether to accept that bid or not

Why priceline works

• to keep their less price-sensitive customers from using this method, airlines force successful Priceline bidders to be flexible:

• to fly at off hours• to make one or more connection• to accept any type of aircraft

• when bidding on groceries, a customer must list “two or more brands you like.”

• as Jay Walker, Priceline’s founder said, “The manufacturers would rather not give you a discount, of course, but if you prove that you’re willing to switch brands, they’re willing to pay to keep you.”

Welfare effects of multimarket price discrimination

• multimarket price discrimination results in inefficient production and consumption

• welfare under multimarket price discrimination is lower than under competition or perfect price discrimination

• welfare may be lower or higher with multimarket price discrimination than with a single-price monopoly

Gray markets

• producers of recordings, books, sunglasses, and shampoo, price discriminate by selling these goods for higher prices in U.S. than in foreign markets

• if the price differential is great enough, some goods are reimported into U.S. and sold in a $130 billion-a-year "gray market" by discounters (Costco, Target, Wal-Mart)

Gray markets (cont.)

• 1995 federal court decision: • copyright owners has exclusive right to control

marketing • can prevent reimportation

• 1998 Supreme Court decision reversed:• discount retailers had the legal right to sell copyrighted

U.S. goods in U.S.• once sold, "lawfully made" copies can be resold

without the permission of copyright holder• reduces firms ability to price discriminate

Other forms of nonlinear pricing

• two-part tariffs• tie-in sales

both are second-degree price discrimination schemes where the average price per unit varies with the number of units consumers buy

Two-part tariff

• firm charges a consumer • lump-sum fee (first tariff) for right to buy any

units• constant price (second tariff) on each unit

purchased

• because of lump-sum fee, consumers pay more, the fewer units they buy

Two-part tariff examples

• telephone service: monthly connection fee, price per minute of use

• car rental firms: charge per-day, price per mile

Personal seat license• Carolina Panthers introduced the PSL in 1993, and

at least 11 NFL teams used a PSL by 2002• over $700 million has been raised by the PSL

portion of this two-part tariff • Raiders football season tickets: “personal seat

license” at $250-$4,000 (right to buy season tickets for next 11 years), tickets $40-$60 each

Two-part tariff with identical consumers

monopoly that knows its customers' demand curve can set a two-part tariff that has same properties as perfect-price-discriminating equilibrium

Two-part tariff with nonidentical consumers

• suppose two customers - Consumer 1 and Consumer 2 - with demand curves, D1 and D2

• consider two cases, monopoly • knows customers’ demand curves and can

charge them different prices• cannot distinguish between types of customers

or cannot charge consumers different prices

Can distinguish/discriminate

• monopoly knows customers’ demand curves; can charge them different prices

• monopoly charges each customer p = MC = m = $10/unit

• thus, makes no profit per unit but sells number of units that maximizes potential CS

• monopoly sets lump-sum fees = potential CS• A1 + B1 + C1 = $2,450 to Consumer 1• A2 + B2 + C2 = $4,050 to Consumer 2• monopoly's total profit= $6,500

Figure Two-Part Tariff with Identical Consumers

p, $ per unit

q1, Units per day

60 70 80

D1

80

20

10

0

mB1 = $600

C1 = $50

A1 = $1,800

Cannot distinguish/discriminate

• monopoly cannot distinguish between types of customers or cannot charge them different prices

• monopoly has to charge each consumer the same lump-sum fee and same p

• due to legal restrictions, telephone company charges all residential customers same monthly fee and same fee per call, even though company knows that consumers' demands vary

p , $ per unit

q1, Units per day607080

D1

80

2010

0

m

(a) Consumer 1

B1 = $600C1 = $50

A1 = $1,800

Figure 12.5 Two-Part Tariff

p, $ per unit

q2, Units per day9010080

D2

2010

0

m

(b) Consumer 2

B2 = $800

C2 = $50

A2 = $3,200

100

Monopoly doesn’t capture all CS

• monopoly charges lump-sum fee equal to potential CS1 or CS2

• because CS2 > CS1 both customers buy if lump-sum fee = CS1

• Consumer 2 buys if monopoly charges lump-sum fee = CS2

• in Figure 12.5, monopoly maximizes its profit by setting lower lump-sum fee and charging p = $20 > MC

Why is price > marginal cost?

• by raising its price, monopoly earns more per unit from both types of customers but lowers its customers’ potential CS

• if monopoly can capture each customer's potential CS by charging different lump-sum fees, it sets p = MC

Tie-in sales

• customers can buy one product only if they purchase another product as well

• most tie-in sales increase efficiency by lowering transaction costs

2 forms of tie-in sales

• requirements tie-in sale: customers who buy one product from a firm must purchase all units of another product from that firm (copiers/toner or service)

• bundling (or a package tie-in sale): two goods are combined so that customers cannot buy either good separately (shoes/shoelaces)

Requirement tie-in sales

• firm cannot tell which customers are going to use its product most (highest willing to pay)

• firms uses requirement tie-in sale to identify heavy users

IBM requirement tie

• 1930s: IBM produced card punch machines, sorters, and tabulating machines that computed using punched cards

• IBM leased (rather than sold) punch machines; lease would terminate if customer used non-IBM card

• by leasing, IBM avoided resale problems and forced customers to buy cards from it

Bundling

• bundling allows firms that can't directly price discriminate to charge customers different prices

• profitability of bundling depends on customers’ tastes and ability to prevent resales

Selling Raiders' season tickets

• suppose stadium can hold all potential customers, so MC = 0 for selling one more ticket

• should Raiders bundle tickets for preseason (“exhibition”) and regular-season games, or sell separately?

Table 12.3 Bundling of Tickets to Football Games

When bundling increases profit

• bundling likely to increase profit if consumers' demands are • negatively correlated: • consumers who value one good much more than other

customers value other good less

• here, bundling pays only if customers willing to pay relatively more for regular-season tickets are not willing to pay as much as others for preseason tickets and vice versa

Supreme Court on tie-in sales

• Kodak was prohibited by the Supreme Court from using certain tie-in sales in 1992

• Kodak sells photocopiers and Kodak parts and service to its customers

• Kodak refused to supply some parts to independent repair firms - effectively forcing customers to buy those parts and associated service from Kodak

Charge and response

• company was charged with illegally tying sale of its photocopiers with its parts and service

• Kodak argued that • case should be dismissed because both sides agreed

Kodak faced substantial competition in initial sale of photocopiers

• customers would not buy from Kodak if they knew that they would be overcharged on repair parts and service

• because Kodak didn't have market power in copier market, it couldn't price discriminate or extend its market power to another market

Supreme Court rejects Kodak

• consumers may be uninformed (can’t forecast repair cost)

• even if Kodak lacks market power in photocopiers, it’s a monopoly supplier of its unique repair parts

• factual investigation needed to determine if consumers are ignorant and have to be protected

• (Court did not explain consumer benefit if Kodak forced to sell repair parts to independent repair shops at prices set by Kodak)

1. Why and how firms price discriminate

• to successfully price discriminate a firm needs• market power• to know which customers will pay more for each unit

of output• to prevent resales

• firm earns a higher profit from price discrimination than uniform pricing because it• captures some or all of the CS of customers who are

willing to pay more than uniform price• sells to some people who won’t buy at uniform price

2. Perfect price discrimination

• to perfectly price discriminate, firm must know maximum amount each customer is willing to pay for each unit of output.

• perfectly price discriminating firm captures all potential consumer surplus

• sells efficient (competitive) level of output• compared to competition

• welfare is same• consumers are worse off• firms are better off

3. Quantity discrimination

• some firms charge customers different prices depending on how many units they purchase

• doing so raises their profits

4. Multimarket price discrimination

• firm does not have enough information to perfectly price discriminate but knows relative elasticities of demand of groups of customers

• firm charges each group a price in proportion to its elasticity of demand

• welfare under multimarket price discrimination is• < under competition/perfect price discrimination• > or < under single-price monopoly

5. Two-part tariffs

• by charging consumers a fee for the right to buy and a price per unit, firms may earn higher profits than from charging only for each unit sold

• if a firm knows demand curves of its customers, it can use two-part tariffs (instead of perfectly price discriminating) to capture all consumer surplus

6. Tie-in sales

• firm may increase its profit by using a tie-in sale: customers can buy one product only if they also purchase another one

• requirement tie-in sale: customers who buy one good must make all of their purchases of another good or service from that firm

• bundling (package tie-in sale): firm sells only a bundle of two goods together

• prices differ across customers under both types of tie-in sales

Docking Their Pay

• 2002 dispute between• the International Longshore and Warehouse Union

(ILWU)• shipping companies, represented by the Pacific

Maritime Association• led to the closure of 29 west coast ports for 12

days and significant damage to U.S. and foreign economies

• these docks handle about $300 billion worth of goods per year

Lockout

• shippers locked out 10,500 union workers• lockout: an action by the employers that

causes a work stoppage similar to what would happen if the union called a strike

Damages

• by one estimate, the shutdown inflicted up to $2 billion a day in damages of the U.S. economy• revenues fell 80% at West Coast Trucking• one of Hawaii’s largest moving companies declared

bankruptcy as a consequence• Singapore’s Neptune Orient Lines said that the

shutdown cost it $1 million a day• Had the shutdown lasted longer, vast amounts of

food and other perishables waiting to be shipped would have spoiled.

Why

• these events were triggered by the expiration of a union contract

• dispute had more to do with employment issues than wages

Background

• number of dock workers has shrunk over the years as firms have used automation to become more efficient

• 10,500 registered union workers averaged at least $80,000 (some estimates set the figure at $100,000) a year with benefits and other perks worth about $42,000 under the previous contract

Offer

Pacific Maritime Association negotiators had offered • $1 billion worth of new pension benefits—

lifetime benefits of $50,000 a year• higher salaries of $114,500 a year for longshore

workers and $137,500 for marine clerks• health care plan with no deductibles

Union Concerns

• use of new technologies• potential loss of 400 longshore positions• wanted guarantees that new clerical

positions would be filled by their union members

Take-it-or-leave it

• Traditionally, longshore unions offered employers a take-it-or-leave-it choice:

• union specified both a wage and a minimum number of hours of work that the employers had to provide

• 1975 U.S. Department of Labor study found 2/3 of transportation union contracts (excluding railroads and airplanes) had wage-employment compared to only 11% of union contracts in all industries

Task

Compare equilibrium where a union specifies both wages and hours of work to the perfect price discrimination equilibrium

w

w*

H* H H, Hours per year

w, wage per hour

B C

Demand

Supply

A